A guide to selling stocks - Part 1

The theory behind selling stocks is pretty simple; the hard part, as always, is putting it into practice.

The question of when to sell a stock is one of the most talked about areas of investing. It’s also one of the most vexing. And it’s no accident that these two things appear together. There are scores of little stockmarket tips thrown around on when to sell, but if you followed most, or even a few, of them, you’d soon get yourself tied up in knots.

‘You’ll never go broke taking a profit’, it is often said, and at first it seems like sensible advice. But you won’t get far in the stockmarket if you sell all your stocks the moment they pass your buy price (and you eventually will end up broke from all the trading costs).

Another tip is to ‘Buy the rumour; sell the fact’, meaning that you should buy stocks when good news is rumoured and sell when it actually appears. The idea is that people tend to overreact to rumours, pushing a stock beyond what’s actually justified by the news. This may be true, but it is of course fuelled by people ‘buying the rumour’.

Perhaps the most curious advice of all is the English ‘Sell in May and go away; don’t buy back ’til St Leger day’. The St Leger Stakes is the last English ‘classic’ horse race of the flat season and is held in early September. The theory goes that you should skip the summer months in the stockmarket (at least in London) because prices will just drift lower as the ‘City’ professionals bunk off to enjoy Wimbledon, Ascot, Henley and all the rest of it. But if everyone did sell in May, then you’d need to be selling in April, and perhaps March and so on. And ditto for buying back in September (or August ... or July ... ).

Means to an end

The truth is that you should make your sell decisions according to basic investing principles. The trick is to remember that profits in the stockmarket come from holding undervalued investments and that buying and selling are simply means to that end. Of course, you also need to combine the right blend of undervalued investments so you’re not too exposed to any particular economic shocks.

So the idea is to maintain a balanced portfolio comprised of the most undervalued stocks you can find. On that basis, you’ll buy a stock if:

(a) it is within your ‘circle of competence’ and you are therefore in a position to make confident assessments of (b) and (c); and

(b) the transaction makes your overall portfolio more undervalued; and

(c) it maintains an acceptable portfolio balance.

You’ll notice that (b) is a relative question. Its answer depends on your assessment of the level of undervaluation of your potential purchase and the level of undervaluation of your existing portfolio—or, more particularly, of the stock you’d sell to provide the funds to make the purchase, which might not be the least undervalued stock in your portfolio, depending on your answer to (c).

So buying and selling are really just two sides of the same coin. Flipping it over, you’d sell a stock if:

(a) it is no longer within your circle of competence and you are not therefore in a position to make confident assessments of (b) and (c); or

(b) the transaction makes your overall portfolio more undervalued; or

(c) it restores an acceptable portfolio balance.

Scrap heap

Note that we have now replaced the ‘and’s with ‘or’s. A stock needs to meet each of (a), (b) and (c) to find a place in your portfolio, but it only has to fail one of the tests to find itself on the scrap heap. But what happens if a stock needs to be sold and you can’t find a suitable replacement? The answer is that you replace it with cash. So the benchmark against which to measure a stock becomes cash, rather than another stock.

As the stockmarket becomes more expensive, and opportunities become thin on the ground, cash becomes an increasingly attractive option and you’ll probably find that your portfolio balance is improved by holding some. In the same way, when more bargains appear, cash becomes less attractive.

The main problem that most people encounter when putting all this theory into practice is overconfidence in their assessments of value, with the result that they make changes to their portfolio far too frequently. After all, with analysts and the media highly polarised on most stocks, it’s never hard to find reasons for buying and selling (in contrast to this, the majority of our recommendations are boring, but realistic, Holds).

Shifting lanes

Most of us are wired up to prefer activity over inactivity and, if you traded a share every time the thought occurred, you’d rapidly hand over your portfolio to your broker. It’s rather like shifting lanes in steady traffic—it feels as though you’re doing some good, but you’re probably just burning through a lot more fuel. Generally speaking, you’d be best to get into a decent-looking lane and stay put.

So, particularly if you’re a bit of a lane-shifter, you may need to take steps to slow yourself down on the trading front. And as with so much in value investing, this probably comes down to ‘margin of safety’: make sure that you only add something to your portfolio when you’re very confident that it improves matters. Having given yourself this margin of safety in the purchase, you can then afford to give the stocks in your portfolio the benefit of any doubt—although there are a few situations where you might flip this around and require stocks to justify themselves again.

So that’s the theory on when to sell. In Part 2 we’ll see how it applies in some practical situations, but we’ll promise to steer clear of any snappy little sayings.

Disclosure: The author, James Carlisle, has been known to get very het up in traffic, shifting lanes far too often. But he is proud of the fact that he’s only made two share sales in the past three years.

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